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Why the Pre-Tax v. Roth Decision is More Complex Than It Seems

Should you make pre-tax or Roth contributions to your retirement plan? With all the news around the election and possible tax changes, we’ve been getting a lot of questions recently about this decision. The basic difference is that with pre-tax contributions, you pay the tax on your contributions and the earnings when you withdraw them while with Roth contributions, you pay the tax on the contributions now but their earnings can be withdrawn tax free. Assuming you’re eligible for a traditional IRA tax deduction, or your employer’s retirement plan offers a Roth option, it can be a difficult choice.

The conventional approach is to compare your current tax bracket with what you think it will be in retirement, which would depend on your taxable income and the tax rates in place when you retire. If you expect it to be lower, go with pre-tax contributions. If you expect it to be higher, go with the Roth. If you’re not sure, go with both.

However, there are a couple of other factors that are often overlooked. One has to do with the way that the tax code is structured. When you contribute to a retirement plan, you’re contributing money that would normally be taxed at your marginal tax rate. However, when you withdraw money in retirement, some of the money is likely to be taxed at some of the lower tax brackets.

For example, let’s take a single person with $60k of taxable income who contributes the maximum $17k to their 401(k). Using current tax brackets, all $17k is income that would normally be taxed at the 25% tax rate. Let’s then assume that they retire with the same $60k of taxable income and that the tax brackets and rates stay the same. When they start withdrawing that money in retirement, they would also seem to be paying the same 25% tax rate, but actually the first $8,700 in taxable income would be taxed at 10%, the next $26,650 would be taxed at 15%, and only the last $24,650 would be taxed at 25%. As a result, the average tax rate would be about 18%. So while at first, this person may have seemed indifferent between Roth and pre-tax contributions, the pre-tax would actually seem to provide a tax advantage.

That’s not the whole story though. Because pre-tax contributions reduce the amount of income tax you owe each year, you can afford to contribute more pre-tax than Roth. If our hypothetical person can afford to max out their Roth 401(k), they can also afford to take the tax savings from pre-tax contributions and invest them in an outside account. The problem is that if that outside account is taxable, they would end up with less money overall in retirement after taxes than if they had maxed out the Roth instead, even after factoring in the lower 18% effective tax rate. On the other hand, if they can invest those tax savings in a Roth IRA, they’ll be better off with the pre-tax 401(k).

So how can you know whether you’ll be better off with Roth or pre-tax contributions? (I realize that the following numbers will be different in retirement due to inflation, but most aspects of the tax code are inflation-adjusted so it shouldn’t affect things too much.)

3) Enter this taxable income into this calculator to estimate your average tax rate in retirement.

4) Use that average tax rate as your “tax bracket (distribution phase)” in this Roth v. Pre-Tax 401(k) calculator, which can factor in the effect of investing pre-tax savings in a taxable account (Option 2).

5) Compare the results.

I suspect that most people would come out as better off with pre-tax contributions using this method (so if you don’t even have access to a Roth 401(k), you’re probably not missing anything). A few caveats are in order though: